What Happens If Interest Rates Stay Low For A Long Time?

If you look closely, it kinda looks like the chart is flipping you the bird.

If you were anything like me in 2010-11, you were probably single, eating a lot of chips, and spending more time in Wal-Mart than your average slack-jawed yokel. Ah, what a time to be alive. I kind of miss those days, except for the not single part.

You were also probably predicting a sharp increase in interest rates would be coming, and soon too. The U.S. economy was well on the road to recovery, yet the bankers at the Federal Reserve were pumping money into the system at an unprecedented pace. All that money in the system would lead to inflation, which would then cause interest rates to spike. WAKE UP SHEEPLE ARMAGEDDON WILL BE SOON UPON US WHERE ARE MY CANNED GOODS?

Okay, I wasn’t quite that crazy, but I did call for interest rates to start heading up sometime in 2012 or 2013. I even went as far as predicting that folks should lock into a 10-year mortgage, like a moron. At least I didn’t rush out and put all my money into gold, because investing in gold is worse than syphilis.

That should really be my tagline, actually.

Obviously, I got the higher rates call wrong, at least so far. But at least I wasn’t alone in making that terrible prediction, since a lot of people joined me by saying rates were bound to go up. Even now, we can all name investors who refuse to invest in bonds because they’re certain rates will go up and crush that asset class like I crush cheeseburgers and the weak-willed.

But I’m not sure that’s going to happen. Take a look at the chart I posted at the top of this article. You’ll notice that between 1930 and the mid-1950s, the Federal Reserve rate in the U.S. never surpassed 2.5%. That is a long-ass time for rates to stay super low.

If you need any evidence that such a thing can happen today, I invite you to look at Japan’s interest rates for the last 20 years.

What gives anyone the confidence to declare that we’re not at the beginning of another 25-year cycle of rates staying this low? What evidence do people who think rates are going to hike soon have besides that they’re really low currently, and we’re about due for a rate hike or seven?

Right now, I’m not seeing any evidence that interest rates are about to start marching upwards in a meaningful way. Yeah, the U.S. looks poised to raise rates in the next month or two, and then might raise again in early 2016. But really, you can make the argument that the U.S. doesn’t really need to hike rates at all. Inflation is barely above zero, and it’s not like anemic bond yields in Treasuries are giving the Fed a huge message that the market is pricing in higher rates.

In fact, you could make the argument that hiking rates could be very bad for the U.S. economy, because it’ll cause the U.S. Dollar to go up even further, which will lower earnings for U.S.-based companies with a lot of foreign operations. That would probably be bad news for U.S. stock markets.

Stop trying to predict rates

I brought this up a few months ago, but it bears repeating. If the smartest minds in the investing world can’t predict interest rates with any sort of regularity, the chances of guys like us doing it is virtually nil.

Which is why most investors shouldn’t even try. They should just focus on owning the assets they want to own and call it a day. If somebody feels comfortable 100% in stocks, then that’s what they should do. Like I care if you blow your brains out at a market top. Those of you reading who aren’t 100% stocks will at least have some dry tinder when the next buying opportunity comes.

(By the way, the Canadian Bond ETF [TSX:XBB] has outperformed the TSX 60 ETF [TSX:XIU] by about 4% so far this year, before dividends. Still think you don’t need even a few bonds?)

If you’re a stock picker like me, just focus on finding value and forget about what the market is doing. When the market is high, finding value will be tougher, thus limiting your investment choices. I’m starting to see some interesting stuff out there, but I’m still mostly staying away.

The conundrum for debt holders

We can’t talk about rates without talking about what mortgage holders should do.

I’m not going to give advice like last time. I have no idea whether you should lock into a 5-year, 10-year, or 149392-year mortgage.

Figuring out what mortgage to choose depends on your risk tolerance. If you don’t want to take on rate risk, then opt for the fixed rate. And if you hate the idea of having debt, it probably makes sense to throw a little extra at the mortgage, even at a sub-3% rate. There’s value in making yourself feel better about your largest debt.

But when choosing a mortgage, or choosing between plunking cash down on a mortgage or investing it, you can’t look too far into the future. You have to make the decision based on what the alternatives are now, and not 5 or 10 years from now.

That’s sort of the crux of the argument. Right now, when compared to bonds yielding between 2-3%, stocks with an earnings yield of 5% look attractive. Ignoring risk, equities will always look more attractive than bonds. Investors are getting a risk premium for just that reason.

What would I do? At least for my portfolio, I’m just assuming that rates will stay the same for a long time. I still hold a healthy bond component, and I’m sitting on some cash as well. I still think the market can decline while bonds pay next to nothing in yield. It happened plenty of times during the 30s and 40s.

I’m not doing this because I’m making a prediction that rates will continue to stay very low. I’m doing it so a) I have cash available to invest during the next downturn, and b) because I want a little insurance against the next big decline. I’m sitting on about 5% of my total assets in fixed income, or about 20% of the money I invest in equities sitting in a combination of debt and GICs.

That’s how I’m playing today’s low interest rates, by assuming they’re here for good. I have no idea whether they are or not, but it sure beats trying to guess.

2 Comments

I think the one thing for certain is that if rates do start to meaningfully climb, it’ll be really easy to predict after it’s happened….

Healthy bond component = 5%? And only 25% in equities? Or is my high school algebra failing me? Does that mean a monster cash / Bitcoin position, a lot of real estate, and/or a ginormous allocation to the engagement ring asset class?

A 149392 year mortgage would be nice. I guess there used to be places (UK) with perpetual / interest-only mortgages, but somehow people got in over their heads. I’m glad we’re generally limited to 30 year ones so that won’t happen anymore.

I have large investments in real estate (approximately 25%), private mortgages (10%), and a private business (10%). I’m also sitting on a bunch of cash I had set aside to buy a house, but I’m not sure what I’ll do with.